You may not hear many Wall Street types talk about it, but there’s more – much more – to investing than just stocks, bonds and real estate. Tax and estate planning laws have plenty of wealth-creating fire power, too, if you know where to look.
Exhibit “A” in this month’s commentary is the Roth IRA. On January 1, 2010, approximately $1.4 trillion worth of U.S. retirement assets, from roughly 13 million investors, will be eligible to be converted to a Roth IRA.
Historically, only investors with an adjusted gross income of under $100,000 were allowed to convert their regular IRAs or their 401k plans to a Roth IRA.
But a time-release capsule in the form of the 2005 Tax Increase Prevention and Reconciliation Act (TIPRA) that triggers next January enables affluent investors to get in on the Roth Conversion train, too. The big advantage? TIPRA eliminates the $100,000 threshold, so now investors of all income levels can benefit from a Roth IRA.
And, for conversions in 2010 only, taxpayers can elect to defer 50% of their tax liability to 2011, and the other half to 2012.
How do Roth IRAs work?
Unlike traditional tax-qualified savings vehicles, Roth IRA contributions are fed with after-tax dollars (versus tax-deferred/tax-deductible contributions such as traditional 401(k) deferrals and deductible traditional IRA contributions).
While Roth IRAs don’t feature tax-deductible contributions, they do enable taxpayers to grow assets on a potentially tax-free basis. But there are some applicable rules. According to the IRS, for Roth IRA earnings to qualify for tax-free “qualified distribution,” five years (at minimum) must elapse from the time of the Roth IRA owner’s initial Roth IRA contribution, and the IRA owner must be at least age 59-1/2.
Why would you want to convert more than $100,000 to a Roth IRA? There is no shortage of reasons.
- Tax-Free Asset Growth – Converting to an IRA can inflate the value of your retirement portfolio by lowering your tax burden. With so many Americans seeing their traditional retirement assets plummet due to the sour economy, the tax hit of converting to a Roth IRA is less substantial. Plus, after the conversion, your brand new Roth IRA account balance can grow free from federal income taxes. Then after you reach age 59-1/2, you can begin to take withdrawals tax-free, when your marginal tax rate may be significantly higher than it is right now. In a relatively low-tax rate environment, a Roth conversion ultimately allows you to pay the low current tax rate when you convert, but you’ll also avoid more onerous federal income tax rates down the road on any post-conversion increase in the value of your Roth account. Consider a $100,000 IRA account that’s decreased in value to $70,000. By converting to a Roth IRA, you would avoid paying taxes on the difference of $30,000.
- Escape Social Security Taxes – Thanks to changes in Social Security taxes in the 1990’s, up to 85% of Social Security benefits are earmarked for IRS payments. But proceeds in Roth IRA distributions are protected from most Social Security taxes. How so? Since tax-free income doesn’t appear on the adjusted gross income line of your income tax form, you not only bypass the taxation of Social Security benefits but you also avoid paying the alternative minimum tax (AMT).
- Lock in Low Tax Rates – No doubt, substantial anxiety and uncertainty exists over the potential for future rising tax rates, and a Roth IRA can help alleviate some of those anxieties. If top marginal tax rates ever exceeded the current 35% rate, a Roth IRA can help act as a hedge against rising taxes. Essentially, you’ll pay tax now when your retirement account value may be relatively weak and while tax rates are still relatively low.
- Estate Planning Benefits – You can protect your family with a Roth IRA, as investors usually don’t pay income tax on IRA assets. Consequently, because family members who inherited Roth IRAs receive the same tax benefits as do the original IRA owners, Roth conversions are an effective weapon in your estate planning arsenal. Consider the case of a non-spouse beneficiaries who must withdraw distributions from an inherited Roth IRA. As long as the withdrawals are deemed as “qualified distributions,“ the recipient usually won’t have to pay income tax on these withdrawals.
Other tax-smart advantages to converting to a Roth IRA include tax loss harvesting, trust planning, and the ability to stretch a retirement account tax-free over the investor’s entire lifetime.
Converting your retirement assets to a Roth IRA can be a savvy move, particularly as the new TIPRA rules take effect next New Year’s Day. Check with your WrapManager Wealth Advocate at (800) 541-7774 or email for more information on how you can execute an IRA conversion.
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